In February, with great fanfare, the government announced a mortgage modification program targeting loans backed by Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). It was designed to stem the surge in foreclosures and give the little guy a chance. A bailout for the average Joe, to fix housing and get the economy back on track.                    

Yet the program has begun with little more than a whimper, as shown by the percentage of eligible mortgages granted trial modifications through July:


Percentage of Eligible Mortgages Granted Trial Modification

JPMorgan Chase (NYSE:JPM)




Citigroup (NYSE:C)


Wells Fargo (NYSE:WFC)


Bank of America (NYSE:BAC)








Select Portfolio






National City**


Source: U.S. Treasury.
*Part of Wells Fargo
**Part of PNC

The slow start might seem strange, because banks are supposed to have an incentive to modify their hearts out. Save a mortgage that would otherwise default, and the bank forgoes the agony of foreclosing -- in theory, anyway. Furthermore, the program gives mortgage servicers incentives -- up to $4,000 -- for every successfully modified mortgage.

So what gives?
Many factors are stalling the modification process, -- not the least of which is the crushing demand banks can't keep up with. But a recent report by the Federal Reserve Bank of Boston gives a few less obvious reasons.

1. They called your bluff
Modifications cost banks money. By either reducing current payments or forgiving debt, the bank is making a sacrifice that benefits the homeowner.

Banks know this. And homeowners know this. Naturally, there's an incentive for homeowners to try to game the system, intentionally skipping payments to become eligible for a modification, even if they don't actually need assistance.

The Boston Fed report elaborates on the outcome of this. In summary: "[M]ore than 30 percent of seriously delinquent borrowers "cure" without receiving a modification; if taken at face value, this means that, in expectation, 30 percent of the money spent on a given modification is wasted."

Thirty percent isn't a trivial number. And it's only logical to assume banks are not oblivious to this fact, declining modifications they feel aren't worthy.  

A recent article in The Wall Street Journal highlighted the brazen tactics some housing counseling services encourage homeowners to take. "Some borrowers say they are being told to stop making loan payments and seek a modification later," the article noted, to which one homeowner responded:

To be told I should do something to put my family in this risky position doesn't make sense. I had a lot of faith in the system. For me, it's really shocking and jarring to see that the system doesn't work.

Shocking, indeed.

2. They think you're a lost cause
As I showed last month, the redefault rate on modifications is ghastly. Ninety days out, nearly half of modifications are back in default, making it nothing more than delaying the inevitable.

Now think of this from a bank's point of view: It can foreclose today and sell the house at today's price, or foreclose down the road, and sell the house at a price that has likely since declined. When prices are falling, it's often more profitable to foreclose today than to give a homeowner a second chance.

Again, from the Boston Fed:

[T]he lender has simply postponed foreclosure; in a world with rapidly falling house prices, the lender will now recover even less in foreclosure. In addition, a borrower who faces a high likelihood of eventually losing the home will do little or nothing to maintain the house or may even contribute to its deterioration, again reducing the expected recovery by the lender.

3. They're basking in fees
Credit card companies love people who don't pay their bills on time. Banks love people who overdraw on their checking account. While this doesn't seem intuitive, the amount of fees they can suck out of delinquent customers is staggeringly large.

Same goes with homeowners. As borrowers miss payments, late fees rack up. The longer they're late, the more fees accrue. And a mortgage servicer often can't collect those fees until the house is sold in foreclosure.

Again, from the Boston Fed: "[T]he rules by which servicers are reimbursed for expenses may provide a perverse incentive to foreclose rather than modify."

In short, foreclosure can be easier, quicker, and perhaps more profitable than a modification. The New York Times quotes a Florida real estate lawyer who summed up this situation nicely:

It frustrates me when I see the government looking to the servicer for the solution, because it will never ever happen. I don't think they're motivated to do modifications at all. They keep hitting the loan all the way through for junk fees. It's a license to do whatever they want.

Granted, this seems to contradict problem No. 2. Thus, note that tacking on fees while waiting to foreclose benefits the mortgage servicer, not the investor that holds the loan (which, in this case, are usually bundled mortgage securities).

Your turn to chime in
Have any stories about the modification process -- for better or worse? We'd love to hear 'em. Feel free to share your thoughts in the comment section below.